Economic Update Summer 2023

The U.S. is currently in late cycle characterized by higher interest rates, rising inventories, and slower economic growth. The odds of a recession have considerably fallen but remain elevated as the effects of aggressive monetary policy filter through the economy. Consumption, which is 65% of the U.S. economy is quite healthy. However, consumer credit is growing at its slowest pace since May 2020. Bank lending is shrinking. The ill effects of tighter financial conditions weigh on future economic growth. Despite coming in better than expected, the Conference Board's index of Leading Indicators has declined for fourteen straight months - at level that has been associated with recessions in the past. The ratio of Leading to Coincident indicators has rolled over and is at five-year lows. Historically, that is a trend that has also been associated with recessions.

The U.S. economy grew at a 2% annualized pace in the first quarter, according to the Commerce Department. Upward revisions in consumer spending and inventories boosted the revised number. Consumer spending, as gauged by personal consumption expenditures, rose 4.2%, the highest quarterly pace since the second quarter of 2021. The recent figure undermines consensus expectation of a mild recession around the corner. The Federal government is spending more than it should to juice economic growth. It is running a budget deficit of $34 billion and continues to spend more than it brings in. The latest GDPNow model estimate for real GDP growth in the second quarter is 2.3%. Moody’s analytics baseline forecast for 2023 and 2024 is economic growth projected to be 1.7%, and 1.1% - lag effects kicking in but no recession.

The US economy cannot slip into a recession with a job market as healthy as this one. Labor reports showed layoffs running well below expectations, indicating that labor market strength has held up even in the face of the Federal Reserve’s interest rate hikes so far. There currently are about 1.7 open positions for every available worker. Unemployment remains extremely low at 3.6%. The labor market is a lagging indicator. Excess labor supply is dwindling. Continuing claims are modestly rising. Even so initial claims, one the better leading indicators of a recession, are not even close to a recession warning. The economy needs 360,000 plus weekly initials claims to say economy is in a recession. The Department of Labor’s most recent report shows the 4-week moving average was 246,750.

Low unemployment is boosting personal income and consumption that normally would be lower after one year of rate hikes. Moody’s Analytics says an 8.7% boost in the Social Security cost-of-living adjustment propped up consumer spending figures. Wages continue to rise at a slowing pace, but after inflation wage growth gains are wiped out by higher cost of living. Families cannot buy the same basket of goods and services before inflation took off to a 40 year high, and cost of debt services is rising.

Higher interest rates are not hitting as fast and hard as in the past as a bulk of households and corporations have refinanced at fixed lower rates of about 3-4%. Housing, an extremely sensitive interest rate sector, is particularly strong in housing construction. The travel and hospitality sectors are hot. The labor market is healthy with workers experiencing nominal income growth supporting consumption.

There also was some good news on the inflation front. On a y/y basis, headline inflation dropped to 3.0%, the lowest level since March 2021 while core CPI dropped to 4.8, which is the lowest reading since October 2021. Inflation is lower than CPI reports because shelter cost is its biggest component and it a lagging input. It is being reported as being higher due to the data lag. Shelter cost is declining. The tightness in Labor markets is still causing wage inflation albeit at a slowing pace. Wage growth has not kept pace with inflation.

Recessions are associated with fast tightening cycles. This tightening cycle is one of the fastest ones. Studying past tightening cycles shows that five hundred basis points of hikes have always led to a recession. This time seems be different because the Federal Reserve is hiking from a zero rate, ultra-stimulative, not from a more common Fed Funds rate in the single mid-digits. Tightening so far has successfully drained the excess cheap money from the economy, caused most inflation indicators to dramatically moderate from 2022 levels, and restrained growth. The US economy could escape a recession because the Federal Funds rate is not excessively constraining growth like in past recessions. It is closer to historical levels associated with slow economic growth.

With unemployment so low and core-inflation above Fed target rate, I expect the Fed to hike again this month and not cut this year. The Fed actions to keep rates higher for longer will grind away on employment and slow down wage growth. The direction of inflation into year-end supports a soft-landing scenario unless the Fed continues to hike beyond July.

The Fed will have a challenging time raising the unemployment rate because workers lose their jobs and find another in the current cycle. At this point, the Fed should solve the problem of inflation not by destroying demand but by providing a supply side solution.